Interest Rates 2000-2013

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Fed Funds 10-yr Treas

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Chapter 5The Behavior of Interest Rates

Interest rate are low today because of: • QE-4, Fed buying $30 b of MBS and $35 b of Treasury bonds each

month.

• Eurozone debt crisis

• Corporate sector excess cash

• Financial institutions’ large surplus funds

Investors will adjust their portfolios in expectation of when the Fed will tighten monetary policy.

• Fed is reducing its of bond buying and could exit QE by the end of 2013 if economic growth accelerates. This will increase Treasury yields and reduce bond prices. So investor demand for longer-term bonds will decline, pushing up interest rates.

• Markets expect Fed to end ZIRP in first quarter of 2015. Fed will raise fed funds rate when the unemployment rate falls below 6.5% and 2-year inflation expectations rise above 2.5%.

• Banks are decreasing interest rate risk by investing short term.

The Big QuestionDoes a MS => i ?

Effects of MS on i1. Liquidity EffectMs , Ms shifts right, i

2. Income EffectMs , Income , Md , Md , i

3. Price Level EffectMs , Permanent Price level , Md , Md , i

4. Expected Inflation EffectMs => e => Bd & Bs (Fisher effect) => i

Answer: Effect of higher M/M on i is ambiguous

If assume Ceteris Paribus

Derivation of Bond Demand CurveAssume1. 1-Yr discount bond (no coupon payments)2. Pays $1,000 face value in one year3. Holding period = 1 year , then return = i = YTM

i = RetE = (F – P)/P

For each P, there is a corresponding i

If P = $950, then i = (1,000 - $950)/950 = 0.053Assume QD = $100 billion

If P = $750, then i = (1,000 - $750)/750 = 0.333Assume QD = $500

Law of Demand (lower price => higher QD) (higher return => higher QD)

Determinants of Asset Demand

QD = f(P/i; Wealth, RE, Risk, Liquidity) + + - +

•Wealth = total resources ownedY => W => DB MPS => W => DB

•RE = C/P + (PEt+1- Pt)/Pt

iEt+1 => PE

t+1 => RE => DB E => relative RE DB relative to other assets

•Risk = degree of return uncertaintyrelative to other assets

•Liquidity = ease and speed of turning asset into cash relative to other assets

Factors That Lower Long-Term Interest Rates by Increasing the Demand for Bonds

Wealth: Economic Expansion => Increasing wealth => increased demand for bonds => Pbonds increases => rbonds

decreases

Expected Interest Rates:Lower expected interest rates in the future => raise the expected return of long-term bonds => increased

demand for bonds => Pbonds increases => rbonds decreases

Stock Market:Lower expected stock prices in the future => expected return on bonds relative to stocks would rise =>

increased demand for bonds => Pbonds increases => rbonds decreases

Expected Inflation:Falling expected rate of inflation => raises the expected return on bonds relative to the expected return on

real assets => increased demand for bonds => Pbonds increases => rbonds decreases

Risk:Increase in riskiness of alternative assets => increased demand for bonds => Pbonds increases => rbonds

decreases

Liquidity:Decreased liquidity of alternative assets => increased demand for bonds => Pbonds increases => rbonds

decreases

Bond Supply CurveRelationship between QS and P

As P , i => less costly for firms to borrow => borrowing => QS

QS = f(P/i; I, E, Def.) +/- + + +

• I = Profitability of investment opportunitiesAD => P => = PY – Costs => I =>Y

• E = Expected inflation (return on real assets)

r = i - E

•Def. = Government Deficits

Evidence on the Fisher Effect in the United States

Evidence on Business Cycles and Interest Rates

Business Fixed Investment(Nonresidential Structures)

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1815

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Annualized Quarter Growth Rate

% Change From Quarter One Year Ago

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Nominal Interest Rates, Real Interest Rates and Inflation Expectations

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Source: Federal Reserve

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Inflation Expectations 10-yr Treas TIPS (10-Yr)

Evidence on Money Growth and Interest Rates

Econ 330

Homework 3Due Friday, February 14

Chapter 5Questions & Applied Problems: 14, 18, 19, 20, 23, 24, 25